Questionable Transactions, What Could It Be and Are They Deductible?

January 29, 2016

What happens when your prized employee turns out not to be the person you thought they were? During the course of the year, especially when going thru your books in preparation for upcoming tax filings, you may discover questionable transactions. For example, after thorough investigation, you find that an employee had sticky fingers and was embezzling funds for several years. Is the loss deductible? When? How is the embezzlement reported to the perpetrator?

Embezzled funds are considered a theft loss, and are deducted in the year discovered, or year in which a reasonable person would have discovered the loss, if earlier. Thus, if the business owner was warned by their advisors of discrepancies but failed to take action; the year of discovery would be the year the owner had been so advised. Therefore, not taking action means that prior year returns would be amended, with the possibility of your business losing the theft loss deduction if the tax returns are out of statute.

In the case where the embezzlement was already deducted, no additional deduction is permitted and no returns need to be amended. An example of this is an employee writing fraudulent checks that were posted to an expense account.

From the perpetrator’s standpoint, embezzlement constitutes income in the year received. All income, whether derived legally or otherwise, is required to be reported on a tax return. Intentionally failing to report income is tax fraud, which comes with potentially severe repercussions to the perpetrator. If there is subsequent restitution, the perpetrator would receive a deduction for that in the year repaid. However, it does not alleviate the initial reporting of the funds as income in the years received.

It may be tempting to file a 1099-MISC or amend the W-2 to report the embezzled funds for each involved year. Nonetheless, these forms are used to report compensation for labor, which certainly is not the case here. The best method of reporting such information is submitting form 3949A. Form 3949A is an Information Referral form that reports to the IRS suspected violations of tax law. Unreported income is one such violation.

The IRS will then pull the involved returns and ascertain whether such income was included. If the IRS suspects that income was not reported, an investigation begins. In this case, the business benefits if the total assessment against the perpetrator is greater than $2 million, as you are now eligible for a Whistleblower award of 15% to 30% of collections. Remember, it was not the FBI that took down Al Capone. It was the IRS.

Prior to filing any forms with the IRS, your business attorney should be consulted to ensure that such filings are consistent with the legal position the business is taking with respect to the employee.

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